Tuesday, January 31, 2012

Excellent report from the McKinsey Global Institute on the global debt deleveraging cycle in the aftermath of the bursting of the sub-prime bubble in 2008.

The report points to the experience of Sweden and Finland with their respective debt deleveraging crises of 1990s, both of which involved two stages. In the first, households, corporations and financial institutions reduce their debt significantly over several years, while economic growth is negative or minimal and government debt rises. In the second phase, growth rebounds and government debt is reduced gradually over many years.

But for the US, South Korea, and Australia, all the ten major developed economies are in the initial stages of the debt deleveraging cycle.

The composition of debt among households, non-financial corporations, financial institutions, and the government varies widely across these ten countries. The total debt of the Japan, driven by government borrowings, and United Kingdom, driven by loans taken by financial institutions, are of great concern.

Ironically, apart from Ireland, the debt positions of the other PIIGS economies does not look as frightening as those of UK and Japan. Only the Irish debt bears striking similarity with that of UK.

The report contrasts the successful recoveries of Sweden and Finland with the relative stagnation of Japan and identifies six critical markers of progress before the economic recovery takes off - the financial sector is stabilized and lending volumes are rising; structural reforms have been implemented; credible medium-term public deficit reduction plans are in place; exports are growing; private investment has resumed; and the housing market is stabilized, with residential construction reviving.

Monday, January 30, 2012

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.

It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.

2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.

This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

Sunday, January 29, 2012

Late last year, General Electric established a new global software center in North California to develop software for what it calls the "Industrial Internet". GE proposes to increase the performance of the sophisticated equipments manufactured by it by embedding them with networked sensors and collecting and analyzing real-time data from them using a layer of software.

While the world of inter-connected, intelligent, and networked-to-maintenance support has been in the ideation stage for some time now, it may be the first big comemrcial plunge by any firm.

GE's industrial equipment is typically instrumented with sensors. The center will be building software for pulling the data from the machines and then analyzing it for insights that reduce costs and improve efficiency and safety... For example, collecting data that shows changes in the mechanical vibrations of a gas turbine can help predict when the equipment will need maintenance. The data... is used to anticipate problems instead of doing repairs after there has been an equipment failure. GE's aviation division... developed a program this year, called "My Engines", for monitoring the performance and health of jet engines in use. Such data analysis... can be used not only for pre-emptive maintenance, but also to fine-tune supply shipments and improve product designs.

The increase in coal production is truly stunning. And this does not take into account the imports. The sheer ability to quickly ramp up production a few times over is the most amazing thing about China's top-down economic growth story.

Saturday, January 28, 2012

Subsidies as a percentage of central government budgetary expenditure is at an all-time high and as a percentage of GDP is fast approaching its 1990-91 peak. The graphic below appear to indicate that the much discussed subsidy reforms over the past two decades may have come to naught.

On the back of weakening rupee and high global oil price, fertilizer and fuel subsidies have risen alarmingly. Fertilizer subsidies, estimated currently at Rs 95000 Cr, are sure to breach Rs 1 lakh Cr. Fuel subsidies are expected to touch Rs 1.3 lakh Cr.

The newly promulgated Food Security Bill, which gives legal entitlement of 7 kg of rice, wheat and coarse grains per month at the rate of Rs 3, Rs 2, and Rs 1 respectively to over 63% of national population, has increased the food subsidy burden by another Rs 27,663 Cr to about Rs 95000 Cr.

Friday, January 27, 2012

The opposition in Italy to President Mario Monti's decision to liberalize the heavily regulated retail trade bears strong echoes with India's experience with opening retail trade to greater foreign participation. As part of the Save Italy reforms, the government plans to deregulate operating hours for commercial venues and permit shopkeepers everywhere to set their own hours, and sharply reduce the norms that once regulated entrepreneurs trying to set up shop.

Although many consumers cheered, thrilled at the prospect of buying their provisions after hours, small-enterprise associations have denounced the new rules, calling them the death knell for mom-and-pop stores already struggling in Italy’s recessionary economy.

"Small retailers in Italy were already being squeezed by competition with supermarkets, not to mention the slumping economy, and that in Rome alone 10,000 small shops had closed in the past three years, putting about 35,000 people out of work. The government has to rethink this whole thing. Otherwise it is only going to help large chain stores."

These steps are part of reforms to open up closed occupations and promote competition. The closed occupations, with their prohibitive entry barriers, have been responsible for stifling competition and bringing about Italy's current state of economic sclerosis. Stiff opposition in Italy to such reforms is not confined to retail trade but also other similarly regulated professions like taxi drivers and pharmacists. Trade groups of each occupation prefer the status quo and are naturally opposed to all such reforms. They present these reforms as an attempt to defile Italy's cultural identity, traditions and history.

Though in both countries, the major source of opposition to liberalized and deregulated retail trade is the fear of competition from major retail chains driving out the smaller mom-and-pop traders, the underlying concerns are very different. In India, the fear is that, given the large share of population being involved in small hand-to-mouth retail trade (kirana shops), there would be massive labour market dislocation that would undermine the country's social stability. In Italy, the concerns are driven by mom-and-pop traders unwilling to forego their secure and comfortable professions and let large retail chains intrude into their markets.

In simple terms, while in the former, the opposition may have a very compelling economic argument, in the latter case, it is plain anti-competitive.

Thursday, January 26, 2012

This post will be provocative. I have a simplified interpretation of India's controversial 2G telecoms spectrum allocation process.

The fundamental issue is that the government of the day decided to allocate the spectrum without any competitive price discovery process, and subsequent events (spectrum resales by a few purchasers) point to the allotment having been made at a steep discount thereby causing huge losses to the public exchequer. In simple terms, the spectrum was sold cheap, and private spectrum purchasers benefitted at the expense of the tax payers.

Critics of the allotment process claim that if the spectrum was auctioned off, as happened with the subsequent 3G auctions, the government would have raised huge amounts. The bidders would have paid close to the actual cost of the spectrum. There would have been no corruption. So what gives?

Here is a thought experiment. I can imagine two forces that were generated by the low spectrum prices.

1. The substantial discounts enabled the telecom operators to keep their initial fixed investments low. They now had resources to spend on technology and more importantly, aggressive expansion. Furthermore, it gave all players the initial cushion to establish the market, without having to over-charge. Such over-pricing is a characteristic feature of any nascent market, as the first generation of firms try to establish themselves. It generally takes time before the market stabilizes and the firms start responding to market competition signals.

2. It cannot be denied that the lower spectrum prices dramatically reduced entry barriers and contributed towards creating an intensely competitive marketplace. The threshold cost to enter the market was lowered. In simple terms, the government subsidized the private operators significantly.

As the private operators got established, the market stabilized, customer base exploded, these two aforementioned factors interacted to generate fierce competition. This competition benefited the customers and the market itself.

Consider the counterfactual. Assume the spectrum was allocated by auctions. It is most certain (especially given the information asymmetry in a new market) that the process would have been affected by "winner's curse", whereby bidders would have quoted a premium on the fair market value. The successful operators would have entered the market with strained balance sheets and limited inclination to be aggressive in their investments and pricing. Instead of spectacular explosion, the market would have grown in fits and starts. Most certainly the government would have had to intervene subsequently to prop up the market with various types of fiscal concessions.

The central point I want to make is that the discounted allocations provided the operators with the required cushion to be aggressive and innovative in a nascent market. This in turn helped lay the foundation for a very competitive and vibrant telecoms market in India. The aforementioned dynamics is true of any emerging market. China is the best and most recent exemplar of the wastage, excesses, and corruption that lubricates such emerging markets.

In any typical emerging market, governments provide considerable fiscal support, directly and indirectly. In its absence, the only way in which a market can emerge is if large foreign competitors, with deep-pockets and a commitment to take sustained losses for some time, enter the market.

Much of this support is not planned and is a response to problems posed by emergent difficulties in the growth process of the particular sector. In fact, there is considerable corruption (sanitized through lobbying which conceals an equally nauseating underbelly of quid-pro-quos) involved in these policy decisions. It would be interesting if we could compare the fiscal support given to sunrise sectors like IT and biotechnology with that given to the mobile telecom sector.

The critical governance question here should be about the extent of malafide discretion involved in the allotment process. The acrimonious post-mortem has revealed that the government, or influential people within the government, played an important role in picking winners and enriching themselves at the cost of the public exchequer. It is this market failure that should be the cause for the greatest concern.

This also raises another question. If auctions would have led the market into a low-level equilibrium and discretionary allotments spawned massive corruption, what is the alternative? What process of allotment would have given the participants with the required cushion and allowed the market to develop fast without causing incentive distortions that spawn corruption? I am not sure there is any such process.

This brings us back to the inevitability, even desirability, of discretionary public policy, espcially in incubating new markets. In the circumstances, the focus should be on minimizing corruption in the discretionary public policy making space.

Wednesday, January 25, 2012

James Suroweicki has an excellent illustration of the way private equity firms make money,

In a typical deal, a private-equity firm buys a company, using some of its own money and some borrowed money. It then tries to improve the performance of the acquired company, with an eye toward cashing out by selling it or taking it public. The key to this strategy is debt: the model encourages firms to borrow as much as possible, since, just as with a mortgage, the less money you put down, the bigger your potential return on investment...

Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge "special dividends". This allowed them to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value — they just redistributed money from the company to the private-equity investors. As a result, private-equity firms are increasingly able to profit even if the companies they run go under—an outcome made much likelier by all the extra borrowing.

In this context, a recent study commissioned by the Financial Times has found that "private equity has proved better at enriching its own managers than producing investment profits for US pension funds over the past decade". Private equity firms follow the "two-twenty" annual fee rule - 2% of the committed capital as management fees and 20% of the share of profits as performance fees. The former covers not just the invested capital for that year, but the entire commitment for a long duration made by the investor. For instance, if a $1bn fund invests $100m in its first year, the $20m management fee would be 2% of committed capital, but 20% of invested capital for that year. This rule change was made by the industry body in 2001 following the massive spurt in demand for investments in private equity firms.

From 1991 to 2000, US pension funds paid an average 2% of invested capital each year in management fees, and received 21% returns, after fees, annually from their private equity investments, according to data from the CEM Benchmarking database. In contrast, after the rule change, in the 2001-10 period, US pension plans on average made only 4.5% annually, after fees, from their investments in private equity, whereas the pension funds paid an average 4% of invested capital each year in management fees on top of the performance fees. The change in returns for investors could not have been more dramatic, especially considering that 2001-07 formed the peak of the financial market bubble.

Paul Krugman points to an old paper by Larry Summers and Andrei Shleifer who had argued that leveraged buyouts are often aimed at "value redistribution" rather than "value creation". Translated into English, this would mean "asset stripping"!

A private equity firm is an asset management company. It creates investment funds that raise most of their money from outside investors (pension funds, insurance companies, rich people, etc.), and then manages those funds. As opposed to a mutual fund, however, instead of buying individual stocks, these funds usually make large investments either in private companies or in public companies that they "take private". While mutual funds and most hedge funds try to make money by guessing where securities prices will go in the future, private equity funds try to make money by taking control of companies and actively managing them.

During howling winter weather two years ago, the thousands of windmills dotting Denmark and its coastline generated so much power that Danes had to pay other countries to take the surplus. The incident was the first of its kind, and lasted only a few hours... Since then, there have been just two more instances in which the price of wind power in Denmark turned negative for a significant period of time because of excess wind.

This draws attention to the problems posed by the intermittancy and volatility of wind power and the need to effectively manage it. Apart from required complementary physical infrastructure, it also requires technologies that can store electricity. With an ambitious off-shore wind power generation plan, Denmark hopes to generate half its power from wind within eight years, up from less than a quarter currently. In this context, it is estimated that the supply of electricity might exceed demand for about 1,000 hours each year by 2020 unless there are substantial changes in the way electricity is managed in Denmark.

Among the technologies and practices being tried out to store wind power include pumping water uphill to reservoirs and releasing them to generate hydro-power later; extracting hydrogen from water through electrolysis and then using it to run fuel cells or synthesize gas to provide power when wind was unavailable; different types of batteries; and storing them in the batteries of electric vehicles.

Tuesday, January 24, 2012

Conventional wisdom would have it that the low labour cost in emerging Asia is the driving force behind outsourced manufacturing. The Times has an excellent article (see also this interactive video) that questions this belief with the example of iPhone. It argues that abundance of mid-level manufacturing skills and the advantages with the dynamics of production in massive scale are the reasons for the rapid growth of outsourced manufacturing to Asia.

Various academics and manufacturing analysts estimate that because labor is such a small part of technology manufacturing, paying American wages would add up to $65 to each iPhone’s expense. Since Apple’s profits are often hundreds of dollars per phone, building domestically, in theory, would still give the company a healthy reward.

But such calculations are, in many respects, meaningless because building the iPhone in the United States would demand much more than hiring Americans — it would require transforming the national and global economies. Apple executives believe there simply aren’t enough American workers with the skills the company needs or factories with sufficient speed and flexibility. Other companies that work with Apple, like Corning, also say they must go abroad.

Apple's iconic iPhone is the exemplar of modern day globalized production,

Though components differ between versions, all iPhones contain hundreds of parts, an estimated 90 percent of which are manufactured abroad. Advanced semiconductors have come from Germany and Taiwan, memory from Korea and Japan, display panels and circuitry from Korea and Taiwan, chipsets from Europe and rare metals from Africa and Asia. And all of it is put together in China.

Among the emerging economies, China has an unparalleled comparative advantage as the electronic products assemly line of the world. Its advantages as the assembler are numerous...

The entire supply chain is in China now... You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours.

... and in leveraging its massive labour force with mid-level manufacturing skills...

China provided engineers at a scale the United States could not match. Apple’s executives had estimated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers eventually involved in manufacturing iPhones. The company’s analysts had forecast it would take as long as nine months to find that many qualified engineers in the United States. In China, it took 15 days.

... finally, China has companies like Foxconn, which can mobilize massive numbers of diligent workers in quick time to deliver on any electronic assembling activity. It writes about the Foxconn City,

The facility has 230,000 employees, many working six days a week, often spending up to 12 hours a day at the plant. Over a quarter of Foxconn’s work force lives in company barracks and many workers earn less than $17 a day... Foxconn employs nearly 300 guards to direct foot traffic so workers are not crushed in doorway bottlenecks. The facility’s central kitchen cooks an average of three tons of pork and 13 tons of rice a day.

Foxconn Technology has dozens of facilities in Asia and Eastern Europe, and in Mexico and Brazil, and it assembles an estimated 40 percent of the world’s consumer electronics for customers like Amazon, Dell, Hewlett-Packard, Motorola, Nintendo, Nokia, Samsung and Sony. They could hire 3,000 people overnight.

The article highlights the critical importance of a large base of mid-level manufacturing skills and the presence of a broad-range of manufacturing supply-chain in the success of any economy. They are essential ingredients to the development of a large manufacturing base. The United States which had these capabilities for many decades has seen them get eroded and has now ceded way to China.

Countries like India, which are waiting in line to emulate the Chinese growth miracle, would do well to appreciate the vital role played by these factors. India has nothing comparable to Foxconn and suffers from acute shortage of mid-level skilled technicians. Attempts to build up supply-chain capacities through growth clusters and special economic zones have borne limited success and that too only in a few sectors. Unless these deficiencies are bridged, India's growth potential will remain just that, potential.

Update 1 (26/1/2012)

NYT investigation reveals serious problems with working conditions in Chinese factories supplying components to consumer electronics firms like Apple. Here is the list of Apple's suppliers.

Monday, January 23, 2012

The Planning Commission (PC) and the Ministry of Home Affairs (MHA) are slugging it out on who should run the prestigious unique identification number project. The decision will be made this week.

Apart from the turf-battles that are commonplace in government, the debate is also one about the fundamental objective of such identity markers. The PC sees Aadhaar as providing a platform to more effectively deliver welfare benefits and improve governance in general. The MHA sees the biometric identity cards as a marker to identify citizens and track immigrants for national security considerations.

Both are obviously divergent objectives. But the country needs both. In simple terms, the debate is superfluous since it should not be a debate about one of them but should be about both. Fortunately, a critical analysis of the objectives of both sides reveals that the differences may not be irreconcilable.

Stripped off all the rhetoric, there are two fundamental issues at the heart of the present controversy. First, MHA questions the rigour associated with the data being collected by UIDAI. Second, it also raises questions about who should control this data and the terms governing its sharing and use.

All this can in turn be reduced to four basic questions. Who should be the enrolment agency? What should be the rigour of data capture process? Who should manage the data? What should be the protocols that define the use of the collected data?

Evidence so far regarding the enrolment process appears to point towards the UIDAI's model of decentralized enrolment, through state-level registrars, being more effective than the RGI’s centralized National Population Register (NPR) model. If any proof of this were needed, one only needs to look at the progress of enrolment in the respective states - 8 million enrolments in the NPR to UIDAI’s 100 million.

The MHA is right to be concerned about the rigour of the enrolment process. But that does not mean that the process should be so rigorous, with the type of multi-step screening now mandated, as to virtually ensure that the enrolment will take years and maybe even decades. The slow progress of NPR enrolments is itself an indicator of the difficulty of pushing ahead with this enrolment strategy. However, it is possible to do a multi-track enrolment whereby the data collected by the Registrars can be topped up with a more rigorous re-validation so as to meet the NPR requirements.

In any case, as the NPR enrolments gather momentum, more invasive MHA enrolment processes will raise concerns about privacy and are bound raise bigger controversies and legal challenges. It is possible to continuously, over a ten year period, build-up the data rigour, through a phased-out manner of validation and rigour enhancement.

Organizationally and in terms of professional competence, there can be little doubt that the UIDAI is better positioned than the Registrar General of India (RGI) in managing the technology platform and database. In any case, given that most of the hardware infrastructure is already in place or its procurement is in progress under the control of the UIDAI, it is only appropriate that it continue and complete the process.

A workable solution to the whole project may be for the UIDAI to manage the technical issue of database management and the MHA to govern the terms of use based on defined protocols. These protocols should be use-specific, and the MHA should have the prerogative, in consultation with all stakeholder departments, to define them. The UIDAI could then administer the process of database sharing with different user departments, based on the protocols defined by the MHA.

This four-pronged approach would enable a reconciliation of the apparently contradictory aims of the two wings of the government. All this should be brought under a legislative framework and should be defined in the Parliamentary Bill that would give statutory basis to the entire process.

The Aadhaar number has benefits that go much beyond its immediate utility by way of enabling user departments to eliminate fraud arising from duplicate, ghost, and impersonation of beneficiaries. The more long-term and functionally high-value utility of the Aadhaar number will come from linking up multiple department databases using the Aadhaar number. Smart data analytics can help reveal inconsistencies within each database and help minimize and even eliminate many categories of inclusion and exclusion errors. It will not only ensure that ineligible beneficiaries are screened out, but also prevent eligible beneficiaries from being excluded.

The massive amounts saved from the elimination of these inclusion errors can be used to improve the quality of service delivery and in other public infrastructure investments. Aadhaar holds equally impressive potential benefits for the private sector. A secure and reliable Aadhaar database and Aadhaar-linked bank accounts will help reduce business transaction and contract costs in many sectors.

There are certain very valid data protection and privacy concerns associated with the Aadhaar project. For a start, it is important to immediately bring the Aadhaar project under a statutory mandate and formulate an enabling policy framework that governs the terms of its use. Adequate care can be taken to ensure that privacy concerns are addressed and only the basic data is made shareable across departments. As already indicated, there should be clear protocols and rules governing the sharing of information across departments.

However, none of this can detract from the undeniable benefits associated with the Aadhaar project. The dangers and concerns are far outweighed by the substantial benefits in improving governance.

Hedge funds have been known to use hardball tactics to make money. Now they have come up with a new one: suing Greece in a human rights court to make good on its bond payments. The novel approach would have the funds arguing in the European Court of Human Rights that Greece had violated bondholder rights, though that could be a multiyear project with no guarantee of a payoff.

One of the terms of the 130 billion euro ($165.5 billion) rescue package for Greece, is to cut its debt by 100 billion euros through 2014 by forcing its bankers to accept a 50% loss on new bonds that they receive in a debt exchange. In addition, the Greek government is unwilling to offer the 4% interest rate on new bonds received in exchange for the old bonds. Hedge funds argue that this will effectively increase the relative haircut to between 60-70%.

Though Greece has been negotiating with its bond holders on voluntary haircuts, in the range of 50% of the debt value, these talks have made little headway. The EU-ECB-IMF had made such haircuts and consequent debt restructuring a mandatory requirement for releasing the next instalment of rescue package funds for Greece.

Many of the bondholders - hedge funds, pension funds, banks, etc - have already insured their positions through credit default swaps and find the deal offered by Greece less attractive than a forced default. But a forced haircut would unnerve the markets and potentially destabilize the global financial markets.

Interestingly, over the past year, despite there being ample evidence of Greece being close to default, several hedge funds have continued to buy into Greek debt. All of them were ttracted by the massive potential returns despite the potential for default and a perceived belief that EU and ECB would let Greece default. A Times report nicely captured the incentives,

"Greece may never be able to pay off its huge debts, but its bonds, long scorned by investors, are suddenly being gobbled up by hedge funds... many have turned their attention to the hot yet risky euro zone trade of the moment: buying Greek government bonds that traders say are changing hands for as little as 36 cents for each euro of face value. The investors hope to book a fat profit on the expectation that the European Union and the International Monetary Fund will once again bail out Greece, fearing a global financial disaster if they do not...

Those speculating in Greek bonds are taking on well-documented risks, not the least of which is the possibility that the country will fail to reach a final agreement with the I.M.F. and the European Union and will not get the next portion of money needed to avoid default."

In fact, a major portion of the current bond holders are not the original ones - large European banks - and are speculative investors who have purchased their bonds in recent months. The Times report estimated that as on September 2011, about 30% of the investors bought their bonds after July 21. This share would surely have climbed in the subsequent months.

I have two observations from these events.

1. The hedge fund managers are obviously playing chicken with Greece and Eurozone. Who will be the first to blink? If they are able to scare Greece, EU, ECB, and the IMF away from forced default and/or to get the IMF and EFSF/EU to accept losses, by amplifying fears of a global financial market contagion (driven by bond market vigilantes), then the hedge funds stand to make fantastic gains. Conversely, the governments could call the bond market bluff and proceed with the haircuts and debt restructuring, thereby imposing serious costs on the hedge funds.

2. The action of the hedge funds in buying into Greek debt despite clear knowledge of all the associated risks bears remarkable similarity to the role of real estate agents in India who scout for lands emrboiled in litigation or whose titles are not clear.

Such lands, embrolied in litigation or uncertainty for many years, even decades, cannot be developed without settling the encumberances by clearing the title. Real estate agents with close political connections see them as opportunities. They buy into these lands, including the litigation, at cheaper than the market rates. Then they use their official connections to either weaken government claim (for example, by making the government advocates soft-peddle on court litigation) and eventually get it transferred to private interests or use political muscle power to arm-twist the other private parties into signing away their interests at a bargain rate.

Such agents, who are present in all Indian cities, and have connections with influential people in the establishment - politicians, officials, and judges - are classic risk managers. They spot the opportunity, weigh pros and cons - risks associated with getting the title cleared off encumberances - and make their investments.

The modus operandi is eerily similar to that of the hedge fund managers who have invested in Greek debt despite enough evidence that Greece would default on its sovereign obligations. Like the real estate agents, all these hedge fund managers wield considerable influence in the corridors of power - governments, central banks, financial market regulators, and big financial institutions. Again, like them, the real estate agents try to leverage this influence to benefit them. In fact, they become confident that with an appropriate mixture of brinkmanship and nudging of the powers-that-be who decide on the terms of the Greek default, they would be able succeed with a favorable debt restructuring deal.

These real estate agents operate purely outside the legal boundaries. However, the trades executed by hedge funds, in the face of very obvious and extreme risks, are perfectly legal. Is there a case for atleast some regulation on such trades?

In the instant case, it was plain obvious, as early as early last year, that haircuts on Greek debt was inevitable. In the circumstances, the only logical reason for hedge funds to pile into Greek bond was a belief that they could influence the debt restructuring process. Given the moral hazard and other incentive distortions created by these actions, is there a case to restrict such trades, especially under such conditions?

Supporters of these trades will obviously point to their positive role in risk diversification by helping banks off-load risks to those best able to bear them. But then this diversification becomes a double-edged sword when the buyers do so on the aforementioned assumptions. Systemic risk then gets amplified instead of being diversified.

Post script - As for Greece itself, even with the deal, its debt would be no less than 120% of GDP in 2020 (down from 140% of GDP at $450 bn today) — which seems to be slight progress given the austerity and pain its citizens must endure during this period.

Friday, January 20, 2012

The National Rural Employment Guarantee Scheme (NREGS), as the name suggests, is an unemployment insurance program for the rural poor. In simple terms, the government steps in as the employer of last resort, with a minimum wage guarantee, if the labourer is not able to find employment in the regular market.

However, an article in The Times of India on 18.1.2012, about an apparent lack of interest for NREGS in Warangal, is a very accurate reflection of the misconceptions about NREGS and its gradual slide from being a demand-driven to a supply-driven program.

The central government’s flagship programme MNREGS has not found many takers in Warangal. This when the district had bagged first place in the state last year in providing work to farm labourers under MNREGS and spent huge funds on works... this year Warangal has fallen to 15th position in the chart... At the recent vigilance and monitoring committee meeting, it was revealed that MNREGS implementation in 2011-12 has come a cropper... According to District Water Management Authority (DWMA) officials, the farm workers are not showing any interest to carry out the MNREGS works as the private sector is ready to pay more for their work.

In states like Andhra Pradesh, even in Warangal, NREGS can no longer be considered as not having takers because of lack of awareness or other high access barriers. In the circumstances, the low demand this year, especially in the backdrop of last year's excellent performance, is most likely to be due to reduced demand. However, instead of viewing the drop in NREGS enrollment this year as an indicator of a stronger economy and more private sector job opportunities with increased wages (say, private farm labour wages having risen, making it more attractive over NREGS), the newspaper article considers it a governance failure.

Such an understanding of the NREGS, representative of the mainstream view of the program, will come in the way of any exit strategy, even if the market is able to provide employment at higher than the NREGS wages. This conception arises when we view NREGS as an end in itself, rather than as a means to insure or protect against a market failure or deficiency. Ironically, its success may itself prove to be NREGS's greatest failing!

The Economist points out that in 2011 China's urban population surpassed its rural population. This stands out in stark contrast to 1980, when less than a fifth of its population lived in cities, a smaller proportion than India, whose urban population share in 2011 was just above 30%.

The rapid pace of urbanization, especially manufacturing led urbanization (where factories are located in cities or its urban agglomerations), has been the primary driving force behind China's spectacular economic growth of the past three decades. In fact, it is no coincidence that China's pace of urbanization picked up sharply since 1995 (as observed from the graphic). This coincided with a rapid spurt in the economic growth.

In contrast, India's urban population has grown slowly, a reflection of its rural-centric growth strategy. State and central governments in India will have to redress this skewedness in priorities in order to push the economy into a sustainably higher growth trajectory.

Thursday, January 19, 2012

The lag in learning levels is truly staggering. The graphic below shows how children in Class V lag behind in reading and basic math.

Worse still, this learning level lag has been increasing over the years in both languages and math. This lag has been increasing steadily over the past four years in both government and private schools. There also exists a considerable, 10-20 percentage points, differential in learning deficiency between private and government schools.

Attendance continues to be a major problem in the traditional BIMARU states. Further, private school penetration remains weak in Bihar, Orissa, Chattisgarh, Jharkhand, and MP.

Wednesday, January 18, 2012

The Subsidies and Countervailing Measures (SCM) Agreement (overview here) of the WTO is an interesting document in many respects. It is also a reflection of the fact that no agreement can be frozen in time and should be dynamic enough to reflect the changing environment.

For the record, the SCM Agreement creates two basic categories of subsidies - those that are prohibited those that are actionable. The former consists of export subsidies (those subsidies contingent on export performance) and local content subsidies (those contingent on the use of domestic over imported goods), both of which directly affect trade and infringe on others interests. The later though not prohibited, can be challenged either through multilateral dispute settlement (in case of exports having to compete with subsidized products) or through countervailing duties (in case of injury to domestic industry due to imports from the infringing country).

Of great relevance to countries like India, especially in light of the recent controversies over trade in renewable power generation equipments, is the restrictive nature of the definition of subsidies within the SCM. Only a measure which is a "specific subsidy" within the meaning of Part I is subject to multilateral disciplines (or the rules regarding whether or not a subsidy may be provided by a Member) and can be subject to countervailing measures. I can see atleast three reasons why this definition is restrictive and comes in the way of achieving fairness in multilateral trade.

1. The agreement requires that any subsidy involve a "financial contribution" that involves a "charge on the public account". They include grants, loans, equity infusions, loan guarantees, fiscal incentives, the provision of goods or services, the purchase of goods. They do not include measures and policies of government that while are not explicitly subsidies, do end up distorting competition. This effectively means that any indirect subsidy by way of "revenues foregone" - lower (than cost-recovery) utility tariffs, low land prices, repressed labour market, artificially cheap capital and so on - are not prohibited. At the least, it is difficult to prove that they attract the provisions of the SCM.

2. The "specificity" provision is another restriction that effectively rules out making a case against universal, economy-wide distortion generating subsidies. The overview to the SCM Agreement makes this very clear,

Assuming that a measure is a subsidy within the meaning of the SCM Agreement, it nevertheless is not subject to the SCM Agreement unless it has been specifically provided to an enterprise or industry or group of enterprises or industries. The basic principle is that a subsidy that distorts the allocation of resources within an economy should be subject to discipline. Where a subsidy is widely available within an economy, such a distortion in the allocation of resources is presumed not to occur. Thus, only "specific" subsidies are subject to the SCM Agreement disciplines.

The underlying premise that a widely available subsidy is non-distortionary holds good only in the context of a closed economy. However, when seen in the context of an open economy facing international competition, such one-side subsidies end up unfairly favoring that side over its competitors.

3. The requirement that any subsidy provide a "benefit" also makes the definition of subsidies restrictive. Benefits, by implication, have a reference to the domestic market place. If the subsidies in that market are universal, then there is no specific "benefit" that adheres to any producer.

In simple terms, the definition of subsidy in the SCM agreement fits in nicely into the international trade strategy and national industrial policy followed by fiscally strong countries like China. It ensures that the sort of subsidies that China today provides to its manufacturers do not infringe the provisions of the SCM Agreement. Even if it do so, it would have been very difficult to establish that these are not permissible subsidies.

With regulatory restrictions (or tariff and quota barriers) prohibited by the national treatment condition of TRIMS and China-type manufacturer subsidies made impossible due to their weak fiscal positions, manufacturers from developing countries are left to fight a lop-sided battle. Their only strategy to combat such trade competition is to indulge in your own set of China-style economy-wide structural subsidies. However, countries like India, which do not have the deep pockets to support their domestic industries, are left with no means to fight such trade competition.

Monday, January 16, 2012

Enlightened public policy, intended or otherwise, has surely played a major part in China's economic success for the past nearly quarter century. However, there remain serious debates about what specific policies contributed to this success.

In this context, a NYT article points to the positive role played by public policy in unleashing fierce economic competition among its city states and the central role of urban development in driving economic growth. Though these city states - semi-autonomous regions within large provinces - are built around a huge urban metropolis, a major portion of its population lives in the rural areas surrounding the city. It writes,

"When it comes to economics, China is more a thin political union composed of semiautonomous cities... than an all-powerful centralized government that uniformly imposes its will on the whole country. And competition among these huge cities is an important reason for China’s economic dynamism. The similar look of China’s megacities masks a rivalry as fierce as that among European countries.

China’s urban economic boom began in the late 1970s as an experiment with market reforms in China’s coastal cities. Shenzhen, the first "special economic zone", has grown from a small fishing village in 1979 into a booming metropolis of 10 million today. Many other cities, from Guangzhou to Tianjin, soon followed the path of market reforms.

Today, cities vie ruthlessly for competitive advantage using tax breaks and other incentives that draw foreign and domestic investors. Smaller cities specialize in particular products, while larger ones flaunt their educational capacity and cultural appeal. It has led to the most rapid urban "economic miracle" in history."

Each of these city states has a municipal government, which administers both the urban and rural parts. A very tightly enforced hukou (household registration) system limits migration into cities. Those living in the countryside are also registered as farmers and receive various welfare benefits. Though the focus of the city governments have hitherto been confined to the urban center, it is now shifting to the countryside, partly in an effort to retain people in the suburbs and villages so that the city does not get too congested and its growth gets choked. Some municipal governments have set up development zones composed of small firms (mainly export-oriented) in the rural areas.

China's experiment has important lessons for India's federal system. Drawing a parallel with Beijing's policy towards city governments, is it possible for the central government to align policy incentives in a manner that helps create an environment that promotes competition among states? What should be the elements of such a policy framework that does not conflict with India's federal system? What should be the support that the central government should provide for each of these elements?

Sunday, January 15, 2012

In the context of the apparent confusion in the ideological position of Tea Party activists (mostly middle-aged and elderly) - though they oppose big government and favor public spending cuts, they want to leave untouched Medicare, Social Security, and public pension system - Lawrence Jacobs' description of American public opinion is spot on

"If you study public opinion, Americans are deeply ambivalent. They hate government in the abstract. But they love government programmes that benefit them in particular."

As historians look back on the sub-prime mortgage meltdown and the Great Recession, one of the things sure to receive considerable attention is the dramatic expansion of central bank balance sheets in their aftermath. As the credit markets froze, central banks emerged as lenders, insurers, and even buyers of last resort in an effort to backstop the slide and maintain financial market stability.

The graphic below captures the true magnitude of the balance sheet expansion by central banks acros developed economies. It is four years old and there are no signs of any exit.

Economist has an excellent graphic and article on the extraordinary monetary accommodation being carried out by central banks across advanced economies.

Update 2 (2/5/2012)

Martin Wolf has this graphic that highlights the dramatic changes that have swept central banking in recent past.

Update 3 (8/5/2012)

Gavyn Davies on the difference between monetary base and monetary aggregates and why the expansion in monetary base does not always lead to inflation,

These are very different types of “money”. The
monetary base is mostly the reserves of the commercial banks held at
the central bank. M1-M4 are mainly deposits of varying maturity held by
the public at the commercial banks. The monetary base can behave very
differently from the wider aggregates, and with very different
consequences for the economy at large.The
recent rise in the monetary base has occurred because the central banks
have purchased sovereign debt from the commercial banks, and have
credited the banks with reserve balances at the central banks to settle
these transactions. Since the commercial banks have simultaneously
wanted to increase their holdings of liquid balances in the safest
possible form, in order to secure their future funding requirements,
these balances have simply remained at the central bank doing nothing...

Monetarist models of the economy generally
assume that there is a fixed ratio between the monetary base and
M1-M4...The fixed relationship between base money and M1-M4 applies when bank
lending is constrained by reserve requirements and banks are eager to
increase their lending. In those circumstances, a rise in the monetary
base or banks’ reserve assets leads to an automatic “multiplier” rise in
bank lending, and then in the bank deposits which comprise the M1-M4
monetary aggregates. None of this is happening now, since bank lending
is not constrained by reserve requirements and banks do not want to
lend.

FT has an excellent article that examines the impact of the Eurozone crisis on the emerging economies. The graphic below highlights the negative effect of Eurozone crisis on the emerging economy bond and equity markets and their currency markets.

Private capital flows to emerging economies have declined, raising questions about financing current account deficits, especially in certain highly stretched economies. As the graphic below shows, the inflows have been declining since the second half of 2010, when the full magnitude of the Eurozone crisis started becoming apparent.

Though emerging economies exports to Eurozone have grown impressively in the past decade, except for the East Europeans, it remains a small proportion of their GDP.

Friday, January 13, 2012

Anecdotal evidence from electoral politics in many Indian states appears to indicate that all the contesting candidates pay reasonably similar amounts of cash bribes to all the voters.

On the face of it, this appears surprising since only one candidate can finally win the electoral race and the electoral race is high stakes and ultra-competitive. In the circumstances, conventional wisdom would have it that atleast some candidates renege on their bribe payments. Further, there should have been a bidding war among contestants to outbid each other in the payment of bribes. So what is the underlying story? Why do "all candidates" bribe "all voters"? Why are the bribes "reasonably similar"?

I am inclined to believe that there are two games being played here. On the one hand, candidates have to weigh the consequence of not making payments given the uncertainty associated with the response of the other side. On the other hand, candidates face the possibility of a potential bidding war in bribe payments.

Consider the first game, which is a defection game. Candidates rationalize bribing voters on the ground that voters have been socialized into expecting bribes and are likely to react negatively (turn against them) if their expectations are not met by any of the candidates. The undeniable reality of an availability bias associated with electoral bribing means that there is a strong likelihood for voters to form expectations about receiving some amount as a bribe. In fact, this expectation is likely to be more pronounced with the incumbent legislator.

The trend is widely pervasive in most parts of India, so much so that any candidate who defects, by not paying or paying less, is perceived to face certain defeat. The table below models a two-candidate electoral game where the decision point is about whether to bribe or not.

This brings us to the second game, the co-operation game. Interestingly, political parties too appear to have internalized the dynamics of the electoral game. Given the inevitability of bribe payments, all of them realize the massive costs associated with a bidding war where one party tries to outbid the other. Since these games are all repeat games, with the same parties fighting over multiple elections, there are sufficient incentives for all sides to embrace an equilibrium and co-operate. The result is an implicit understanding about the magnitude of their bribe payouts. The table below captures this game.

However, there is a small Bayesian twist to this tale which highlights the slippery slope down which both candidates and voters have slipped. Since all parties bribe voters, and voters have to make an electoral choice, they end up making their actual choices based on other considerations. But this choice is conditional on the receipt of bribes. In other words, while voters may make their choice based on several factors, this choice is mostly restricted to those who have paid the bribes. If this line of analysis is true, then all candidates end up defecting and bribing, resulting in a Nash equilibrium. Ironically, atleast in the short-run, the real winner in this is the voter!

So, conditional on receipt of the bribes, what are the factors that drive voting choices? A few intuitive answers include those who paid the larger amount, those perceived as leading the electoral race, those who have struck a chord with some local or emotional issue, and sometimes even those who are perceived as extremely corrupt. Given this, do we have a window of opportunity here to align the individual incentives of voters with general public interest and drive the agenda of contesting candidates accordingly?

Thursday, January 12, 2012

I have blogged earlier about the fact that when controlled for demographic factors, Japan's economic performance since the nineties becomes much less dismal than what conventional wisdom would have it. What's more, assuming the working population as the measure of the country's productive capacity, it can be safely concluded that Japan has been successful in squeezing out the most from its shrinking working population.

A NYT op-ed by Eamonn Fingleton lays bare Japan's impressive achievements over the past two decades that belie the laughing-stock and pitiable image that the country has inspired in recent years.

In many areas, its achievements during the period are hugely impressive, especially given the challenges overcome - average life expectancy at birth grew by 4.2 years — to 83 years from 78.8 years — between 1989 and 2009, 4.8 years longer than Americans; despite starting out late, of the 50 cities in the world with the fastest Internet service, 38 were in Japan, compared to only 3 in the US; measured from the end of 1989, the yen has risen 87 percent against the US dollar and 94 percent against the British pound; unemployment rate is 4.2 percent, about half of that in the US; its current account surplus rose more than three-fold since 1989 to $196 billion in 2010, even as America’s ballooned to $471 billion from $99 billion in that time; and Japan has increased its exports to China more than 14-fold since 1989 and Chinese-Japanese bilateral trade remains in broad balance.

It is not just that Japan is chalking up impressive numbers, even in quality of life, it is a leader.

"An example is Japan’s eating-out culture. Tokyo, according to the Michelin Guide, boasts 16 of the world’s top-ranked restaurants, versus a mere 10 for the runner-up, Paris. Similarly Japan as a whole beats France in the Michelin ratings... the Japanese are consistently among the world’s earliest adopters. If anything, it is Americans who have been lagging... The Japanese are dressed better than Americans. They have the latest cars, including Porsches, Audis, Mercedes-Benzes and all the finest models. I have never seen so many spoiled pets. And the physical infrastructure of the country keeps improving and evolving."

However, as Paul Krugman, Matt Yglesias, and Noah Smith write, while there is considerable merit in the argument that Japan's demise has been overstated, it also cannot be denied that its economic performance since the early nineties has been dismal. Further, atleast some of the apparent successes of Japan may not be indicative of its economic strength.

But as Krugman writes, the most impressive achievement of Japan has been that its ability to mitigate the sufferings of its population despite the long-drawn period of economic stagnation. This statistic pointed out by Krugman about Japan's demographics is stunning,

"According to OECD numbers, in 1990 there were 86 million Japanese between the ages of 15 and 64; by 2007, that was down to 83 million. Meanwhile, the US working-age population rose from 164 million to 202 million."

Update 1 (13/2/2013)

Paul Krugman and Noah Smith have excellent posts explaining the demographics behind Japan's woes. When the relative GDP per working age adult is taken into consideration, Japan does far better than even the US in the 2000-07 period.

The Comptroller and Auditor General (CAG) in its report tabled in parliament last year, found that as against the statutory 33.9%, 179 top companies with profit before tax (PBT) of Rs500 crore and above paid an effective tax rate of 22.1% in 2008-09. On the other hand, the effective rate for the companies up to PBT of only Rs1 crore was more at 25.5%, suggesting that tax concessions are being availed of mainly by large companies.

Wednesday, January 11, 2012

As India embarks on an ambitious program to rapidly expand its solar generation capacity to 20000 mW by 2022 under the Jawaharlal Nehru National Solar Mission (JNNSM), there are several important policy issues that need to be carefully addressed. I had blogged earlier about the uncertainty associated with the recent solar auctions due to the extraordinarily low tariffs quoted by successful bidders.

Another issue that needs to be addressed immediately involves the extent of policy protection permissible to local manufacturers without infringing on the WTO commitments. In recent months, Indian solar panel manufacturers have raised the pitch by accusing Chinese manufacturers of dumping and have called on the government to provide trade protection against them. The Indian firms are seeking anti-dumping duties on Chinese exports and also a 15% tariff on imports of thin-film solar panels (where American firms lead and which is the preferred choice for Indian developers). They complain that US and Chinese imports can be brought into the country tax-free, whereas Indian manufacturers have to pay duties on raw materials to make the same products. They also argue that Chinese firms benefit from cash grants, raw-materials discounts, preferential loans, tax incentives and cheaper currency.

The JNNSM provides for protection to domestic industry so as to catalyze the development of local panel and cell manufacturers. It mandates use of only indigenous crystalline silicon solar panels and solar cells. Furthermore, domestic content (equipment and technology) requirement will gradually increase under the mission. It exempts thin-film panels, which is more sophisticated and has limited Indian production capacity, from the indigenous production requirement. However, this local production requirement has not helped trigger much domestic manufacturing activity in solar sector.

Low-cost Chinese rivals like Suntech and Trina Solar Ltd (TSL) and US firms backed by preferential trade finance including First Solar, the world's largest thin-film panel maker, have reaped most of the equipment orders for 1,100 megawatts of plants to be built by January 2012. Indian suppliers such as Tata BP Solar India, Indosolar Ltd and Moser Baer India (MBI) have received almost no orders from developers building plants in India and are producing far below their factories’ full capacity.

India’s total manufacturing capacity is about 1,500 MW of panels and 500 MW of cells. Indsolar, India's biggest cell company, stopped production in June and has defaulted on 2.75 billion rupees ($52 million) of long-term bank loans as its business became "unviable". Cell prices have plunged 62% to about 52 cents just in 2011 alone on the back of intense Chinese competition and declining demand in Europe where governments have cut subsidies.

The global trade in solar power equipment making in particular and renewables in general have been marked by acrimonious accusations of unfair trade practices. For some time now, US manufacturers have been lobbying hard for imposing anti-dumping duties on Chinese imports. India's local production requirement for solar equipments has been criticised by US, EU and Japan.

It is important that any national policy to facilitate the development of domestic industry are in conformity with India's WTO obligations. However, it would appear that the prevailing policy support to promote local production stand in contravention to WTO provisions. Unlike cash-rich China, where government provides direct subsidies to manufacturers, the fiscally strained Indian government has preferred to mandate local production requirement.

The WTO’s Article III: 4 of Trade Related Investment Measures (TRIMS) and General Agreement on Tariffs and Trade (GATT) III prohibits protectionism and discriminatory treatment against imported products and in favour of domestic products (the national treatment rule). It cannot mandate a private project developer to use only domestic content, though if government is the procurement agency, it can choose between domestic and imported content.

However, Article III 8 allows for payments of subsidies to domestic producers and consumers. This means that the government's purchase of electricity at high price and provision at a lower rate to the consumer is itself not violative of WTO treaty provisions. But, with the Chinese, this subsidy is provided directly to the producer. It is this exemption given to subsidizing domestic producers that has enabled Chinese exporters to avoid infringing WTO regulations. In 2010 alone, Chinese Development Bank gave $30 billion in low-cost loans to top five domestic solar panel manufacturers.

Interestingly, given that direct subsidy to its producers is its preferred method of industrial policy, China is able to skirt around the WTO agreement and massively subsidize its exporters. Such top-down direct subsidies and forcing them to compete for global market share is possible because China has deep pockets. Other countries cannot afford an industrial policy that subsidizes their domestic producers and therefore prefer to impose regulatory restrictions on foreign competitors and imports.

It is ironical that this provision of the WTO regulations which now the Chinese invoke with such devastating effect was itself the preferred route of industrial policy for the western economies for many years. Now the shoe is on the other feet. China has the comparative advantage with subsidizing its domestic manufacturers while the US and India are left to fend the Chinese onslaught with regulatory restrictions - higher tariffs or anti-dumping duties.

Given the changed dynamics of the global economy, it may now be in the interest of developed countries and emerging economies like India to propose renegotiating Article III 8 of the WTO treaty so as to restrain China's industrial policy. If tariff protection and subsidies are two sides of the same coin, then there is a strong case in favor of establishing some balance between Article III 4 and 8 of the WTO treaty.

Tuesday, January 10, 2012

Nobody disputes that teacher quality is central to improving student learning outcomes. But there is limited agreement on how teacher quality should be measured. The simplest and commonplace method has been to use standardized test scores to assess teacher quality. But its flaws are all too obvious - grade inflation, does not control for socio-economic backgrounds of children etc.

In this context, there has been considerable interest and debate surrounding the use of teacher "value addition" (VA) - by using their students’ test score gains - as the preferred metric to measure teacher quality. A teacher's VA is defined as average test-score gain for his or her students, adjusted for differences across classrooms in student characteristics (such as their previous scores). However, its critics have raised the same questions arguing that students are not randmoly assigned to teachers and therefore VA measures have the same flaws as standardized test scores.

A newly released longitudinal research study that tracked 2.5 million students in the US over 20 years by Raj Chetty, John N. Friedman, and Jonah E. Rockoff (presentation slide here) and assessed the value addition of teachers over the long term. Controlling for numerous factors, including student socio-economic backgrounds, they found that value-added scores consistently identified some teachers as better than others. They write,

"Are teachers’ impacts on students’ test scores ("value-added") a good measure of their quality? This question has sparked debate largely because of disagreement about (1) whether value-added (VA) provides unbiased estimates of teachers’ impacts on student achievement and (2) whether high-VA teachers improve students’ long-term outcomes. We address these two issues by analyzing school district data from grades 3-8 for 2.5 million children linked to tax records on parent characteristics and adult outcomes. We find no evidence of bias in VA estimates using previously unobserved parent characteristics and a quasi-experimental research design based on changes in teaching staff. Students assigned to high-VA teachers are more likely to attend college, attend higher-ranked colleges, earn higher salaries, live in higher SES neighborhoods, and save more for retirement. They are also less likely to have children as teenagers. Teachers have large impacts in all grades from 4 to 8. On average, a one standard deviation improvment in teacher VA in a single grade raises earnings by about 1% at age 28. Replacing a teacher whose VA is in the bottom 5% with an average teacher would increase students’ lifetime income by more than $250,000 for the average classroom in our sample. We conclude that good teachers create substantial economic value and that test score impacts are helpful in identifying such teachers."

"Replacing a poor teacher with an average one would raise a single classroom’s lifetime earnings by about $266,000, the economists estimate. Multiply that by a career’s worth of classrooms. If you leave a low value-added teacher in your school for 10 years, rather than replacing him with an average teacher, you are hypothetically talking about $2.5 million in lost income."

As the graphic below shows, when a high value-added (top 5%) teacher enters a school, end-of-school-year test scores in the grade he or she teaches rise immediately.

A few observations

1. There cannot be any denying the fact that quantitative measures of student performance have to be at the center of any meaningful attempt to measure student learning outcomes and bring in accountability in teachers. Data analytics that mine this database can help draw decision-support inferences.

2. Even with all its flaws of cheating in tests, teachers cherry-picking students, and some good teachers taking the fall, VA measure may be, atleast for now, least worse among all bad frameworks to measure teacher quality.

3. The effectiveness and credibility of teacher VA measures can be improved by adding a qualitative dimension to assessment. Such assessments can take care of the several intangible factors that while critical to moulding students are not often captured in test scores.

4. Such assessment measures should not be used for high-stakes decisions. It should be used to identify deficiencies and put in place mechanisms to address them, through, for example, more focussed and targeted trainings for teachers etc.

5. Counter-intuitively, teacher VA measures may be more reliable and credible measure of teacher quality in government schools in countries like India because the socio-economic backgrounds of children are more or less similar. It is also much easier to capture major differences in social categories - religion, caste etc - and control for them in the VA measures.

6. Finally, such measures become more accurate as it accumulates years of data and larger sample sizes, which enable drawing more credible longer-term conclusions. In this context, it becomes possible to kick-in high-stakes decisions like say salary increments to senior teachers.

The New York City makes public value added ratings of 18,000 city school teachers amidst strong opposition from unions who lost the court battle to stop its release. The ratings, known as teacher data reports, covered three school years ending in 2010, and are intended to show how much value individual teachers add by measuring how much their students’ test scores exceeded or fell short of expectations based on demographics and prior performance. In 2010, The Los Angeles Times had hired a statistician and published its own set of ratings.

Such ratings have been gaining currency, in part because they are favored by the Obama administration’s Race to the Top initiative, which makes adoption of such measures a precondition for receipt of federal funds. New York City principals have made them a part of tenure decisions. Houston gave bonuses based in part on value-added measures, though that program was reorganized. In Washington, poorly rated teachers have lost their jobs.